Congress Should End the Economic War Among the States

[The Constitution] was framed upon the theory that the peoples
of the several states must sink or swim together, and that in
the long run prosperity and salvation are in union and not division.
Justice Benjamin Cardozo
U.S. Supreme Court, 1934[1]

Recently, St. Louis, Mo., pursued an aggressive economic development
initiative to lure a professional football team, at a cost to state
and local taxpayers estimated as high as $720 million.[2] Last year, Amarillo, Texas, decided to undertake an aggressive economic
development initiative using a different strategy. Some 1,300 companies
around the country were each sent a check for $8 million that the
company could cash if it committed to creating 700 new jobs in Amarillo.[3]

What is so remarkable about these two initiatives is that they
are not remarkable. Competition among states for new and existing
businesses has become the rule rather than the exception. A 1993
survey conducted by the Arizona Department of Revenue found that
states' use of subsidies and preferential taxes to retain and attract
specific businesses is widespread.[4] The survey found that half the states had recently enacted financial
incentives to induce companies to locate, stay or expand in the
state. Targeted businesses have ranged from airline maintenance
facilities, automobile assembly plants and professional sports teams
to chopstick factories and corn processing facilities.

While states spend billions of dollars competing with one another
to retain and attract businesses, they struggle to provide such
public goods as schools and libraries, police and fire protection,
and the roads, bridges and parks that are critical to the success
of any community.[5] Surely, something
is wrong with this picture! As Justice Cardozo suggested, the framers
of the Constitution had something different in mind in granting
Congress the power to regulate interstate commerce under the Commerce
Clause. The objective was to create an economic union, particularly
by ending the trade war among the states that prevailed under the
Articles of Confederation. However, it was the Supreme Court, not
Congress, that applied the Commerce Clause to end the trade war
among the states.

In this essay we argue that it is now time for Congress to exercise
its Commerce Clause power to end another economic war among the
states. It is a war in which states are actively competing with
one another for businesses by offering subsidies and preferential
taxes. While the Court has not confronted the constitutionality
of states engaging in these activities, it has expressed the view
that these activities may be "admirable,"[6] and it would probably find that they fulfill a legitimate local
public purpose. Economists reach a much different conclusion. They
find that there is a role for competition among states when it takes
the form of a general tax and spend policy. Such competition leads
states to provide a more efficient allocation of public and private
goods. But when that competition takes the form of preferential
treatment for specific businesses, not only is it not "admirable,"
it interferes with interstate commerce and undermines the national
economic union by misallocating resources and causing states to
provide too few public goods. Moreover, the success of a state in
attracting and retaining particular businesses is not a mitigating
circumstance.

The economic merits of ending the war among the states

To understand why economists conclude that the use of public funds
to attract and retain specific businesses does not serve a legitimate
local public purpose, we need to understand what they mean by public
purpose. Economists' view of public purpose relies critically on
a distinction between public and private goods. A public good, unlike
a private good, is one in which a single person's consumption of
that good does not subtract from another person's consumption. A
lighthouse is an often cited example of a pure public good: The
light from a lighthouse used by one ship on a foggy night does not
prevent its use by another ship. Providing for the national defense,
clean air and a legal system are other examples of goods that any
citizen can consume without subtracting from what can be consumed
by any other citizen in the community.

Besides pure public goods there are some goods that lack the explicit
quality of a public good but give off external effects that qualify
them as such. Health care provided to an individual is a private
good because it subtracts from the consumption of other individuals;
nevertheless, it may have external effects that are public. For
example, having one person inoculated for some communicable disease
makes for a healthier environment, and a healthier environment is
a good that any person can consume without subtracting from the
consumption of any other person. Similarly, educational services
consumed by one individual subtract from the consumption of other
individuals, but education increases a community's stock of knowledge
and is critical to a well-functioning democracy, two highly regarded
public goods.

Economists have found that while the production of private goods
is best left to market forces, the production of public goods should
be the principal role of government because the market fails to
produce enough public goods. The reason the market fails is that
since people cannot be excluded from consuming public goods, charging
people for what they consume is difficult. It is often impossible
to say if and how much of a public good a person consumes. How much
does one consume of a healthy environment, or national defense or
a lighthouse beam? A private firm producing a public good might
try to survey the citizens of its community to uncover how much
each consumes of a public good and charge accordingly. However,
knowing they will be charged based on how much they say they benefit
from the public good, and knowing they will get to consume as much
as they want, regardless of the charge, people will tend to understate
the benefits. Moreover, private firms could not enforce payment
for such goods even if they knew how much to provide. Consequently,
left to the market, too few public goods, if any, will be produced.

We turn to the government, then, to finance and provide for the
use of public goods. Government, by its very nature, can solve the
financing problem for it has the power to appropriate funds from
its citizens (the power to tax) for the provision of public goods.
Solving the provision problem of public goods is more difficult.

Competition among states through general tax and spend policies
leads to the right amount of public goods

For state and local governments there is a form of intergovernment
competition that guides them to provide the right amount of public
goods. This type of competition among government entities has been
compared to the invisible hand that guides private business to produce
the right amount of private goods.

Charles M. Tiebout argued in 1956 that as state and local governments
compete through general tax and spending programs to attract people
and businesses, these government entities are led to produce the
desired level of public goods. Tiebout notes that people can vote
with their feet and choose to live in the community that provides
them with the public services for which they are willing to pay.
As a result, people in effect reveal their true preferences, and
state and local governments provide more public goods than if these
governments were not competing. The problem of providing the right
level of public goods is alleviated by competition among state and
local government entities.

But competition among states for specific businesses is harmful

When states compete through subsidies and preferential taxes for
specific businesses, the overall economy suffers. From the states'
point of view each may appear better off competing for particular
businesses, but the overall economy ends up with less of both private
and public goods than if such competition was prohibited.

State and local officials often boast about the new businesses
they have attracted, the old ones they have retained and the number
of jobs they have created. And in many instances these officials
should boast. They have either managed to maintain their tax base
by enticing a local business to stay or they have added to their
tax base by enticing an out-of-state business to relocate. As long
as the subsidies and preferential taxes given to a business are
worth less than the revenue the business will contribute to the
state over its operating years, the citizens of the state are better
off than if their state officials had not played this competitive
game. The state has more jobs and hence more tax revenue to pay
for public goods than if it had not competed.

But even though it is rational for individual states to compete
for specific businesses, the overall economy is worse off for their
efforts. Economists have found that if states are prohibited from
competing for specific businesses there will be more public and
private goods for all citizens to consume.[7] To illustrate this point, we will consider several possible outcomes
of this competition.

In the first outcome, no business actually moves to a new location.
In other words, suppose that each state goes on the offensive to
lure businesses away from other states, but defensive strategies
prevail; local subsidies and preferential taxes to businesses that
might consider moving, keep them from leaving. While each state
could claim a victory of sorts (for no state loses a business),
clearly all states are worse off than if they had not competed.
Competition has simply led states to give away a portion of their
tax revenue to local businesses; consequently, they have fewer resources
to spend on public goods, and the country as a whole has too few
public goods.

It is unlikely, of course, that businesses will not be enticed
to relocate. In this second outcome, the damage to the overall economy
can be even greater. At first glance, when businesses relocate there
appears to be no net loss to the overall economy; jobs that one
state loses another gains. Yet on closer examination we can see
that this is not just a zero-sum game. As in the case with no relocations,
there will be fewer public goods produced in the overall economy
because, in the aggregate, states will have less revenue. This follows
because the revenue decline in the losing states must be greater
than the revenue increase in the winning states. (If this was not
true, businesses would not have relocated.) In addition to this
loss, the overall economy becomes less efficient because output
will be lost as businesses are enticed to move from their optimal
locations.

Each business that is enticed to relocate represents a potential
loss of efficiency for the overall economy and hence less output,
less tax revenue and fewer public and private goods. To be more
concrete, let us suppose a company chooses to relocate its manufacturing
plant from a warm climate state, like Louisiana, to Alaska, even
though its operating costs are substantially higher in a cold weather
climate. We will assume that the company is more than fully compensated
by Alaska for the move and for the additional operating costs. However,
it now takes more resources for this company to produce the same
quantity of output in Alaska than it did in Louisiana.

There is another reason businesses will be less productive when
states are allowed to compete for individual businesses. States
may increase taxes on those firms that are less likely to move to
offset the lost revenue from firms that have moved (or have threatened
to move). It is a well-known proposition in economics that taxes
generally distort economic decisions and at an increasing rate.
Business taxes, in particular, induce firms to produce less efficiently.
Again to make the argument concrete, consider the hypothetical example
of a tax on machines like those used in car washes. Without a tax
or with a very small tax, the most efficient and profitable way
to operate a car wash is to invest in high quality machines that
require only few workers. As the tax increases, the most profitable
way to operate the car wash will be to invest in less sophisticated
machines that require more labor; although fewer cars will be washed
per day, having less expensive machines reduces the tax payment,
more than compensating for the lower productivity. And since tax
distortions generally grow at an increasing rate, at higher tax
rates relatively fewer cars are washed.

In general, it can be shown that the optimal tax (the tax that
distorts the least) is one that is uniformly applied to all businesses.
Allowing states to have a discriminatory tax policy, one that is
based on location preferences or degree of mobility, therefore,
will result in the overall economy yielding fewer private and public
goods.[8]

State competition for specific businesses involves one additional
loss that could make those already mentioned pale by comparison.
We have assumed that states have the information to understand the
businesses they are courting; that is, their willingness to move,
how long they will stay in existence and how much tax revenue they
will generate. In practice, states have much less than perfect information.
Assuming all states are so handicapped, they will on average end
up with fewer jobs and tax revenues than they had anticipated, and
at times the competition may not even be worth winning.

For example, Pennsylvania, bidding for a Volkswagen factory in
1978, gave a $71 million incentive package for a factory that was
projected to eventually employ 20,000 workers. The factory never
employed more than 6,000 and was closed within a decade.

Minnesota's 1991 deal with Northwest Airlines is another example
of a Pyrrhic victory. A state agency agreed to provide the company
with a $270 million operating loan at a very favorable rate of interest.
In return, Northwest agreed to build (with an additional $400 million
of state and local government funding) two airplane repair facilities
that would eventually employ up to 2,000 highly skilled workers
in an economically depressed region of the state. While the operating
loan was made in the spring of 1992, the company has yet to fulfill
its part of the bargain. Moreover, the commitment to build the two
repair facilities that would employ 2,000 workers has been reduced
to a commitment to build one very modest facility and an airline
reservation center, which together would employ fewer than 1,000
workers.

Despite the fact that state deals have gone sour, some may still
be tempted to argue that competition among states for specific businesses
will lead to a good outcome for the overall economy. Some may be
tempted to make this argument because it seems, as we argued earlier
in this essay, people can vote with their feet (or vote policymakers
out of office). Hence, if people are unhappy with their state's
economic development strategy, there is an internal political check.
People, however, may not be unhappy with these strategies--the state
is acting in their best interest. Not to compete, while other states
are, may be detrimental to a state's economy. Moreover, there may
not be a place to go because all states may be competing. For this
type of competition there is no invisible hand (or more accurately,
no invisible foot) to lead states to do what is best for the country.

Only Congress can end the war among the states

How can this war among the states be brought to an end? The states
won't end this war, and the courts are not equipped to do so. Only
federal legislation can prevent states from using subsidies and
preferential taxes to attract and retain businesses.

The powers granted to Congress under the Constitution enable it
to fashion the legislative tools necessary to prevent the states
from using subsidies and preferential taxes to attract and retain
businesses. For example, Congress could tax the receiving business
on the direct and imputed value of these benefits, it could deny
tax-exempt status on debt of states that offer such subsidies, or
it could deny federal funding that would otherwise be payable to
such states, much as it denies highway funds to states that fail
to meet federal pollution standards.

The states

The states won't, on their own, stop using subsidies and preferential
taxes to attract and retain businesses. There is anecdotal evidence
that some state and local governments recognize they are all losing
in this economic war. Nevertheless, as long as a single state engages
in this practice, others will feel compelled to compete. New York,
New Jersey and Connecticut all recognized that they were losing
from this competition, and in 1991 they informally agreed to stop
competing with each other. It was not long, however, before New
Jersey broke the deal.

Even if a number of states were interested in formally agreeing
to stop the practice of competing to attract and retain businesses,
it would be a practical impossibility to devise an arrangement that
would both cover all the forms of subsidies and preferential taxes
the states might devise and provide an effective method of enforcement.
Also, such a multistate treaty might run afoul of the Compact Clause
of the Constitution, which prohibits a state from entering into
a compact with another state, in the absence of the consent of Congress.

The courts

To understand why this problem cannot be left to the courts, it
is important to know something of the history and purpose of the
Commerce Clause and the role that the courts[9] played in its evolution and application.

The economic union—from the Articles of Confederation
to the Constitution

A driving force in the nation's movement from the Articles of
Confederation to the Constitution was that the Articles did not
provide a national economic union. The Annapolis Convention of 1786
was convened to discuss the removal of the impediments to commercial
activity, both among the states and between the United States and
foreign nations, under the Articles. It ended with a call for a
meeting the following year to discuss changes to the Articles to
correct the defects that adversely affected commerce. The 1787 meeting
evolved into the Constitutional Convention as it became apparent
that the commercial problems could not be remedied by simply amending
the Articles.

Under the Articles, the states had freely engaged in destructive
economic warfare by imposing all types of trade barriers against
one another. To address this, James Madison, the recognized father
of the Constitution, added the Commerce Clause to the Constitution,
to help promote an economic union of the states. The Commerce Clause
grants Congress the power to regulate "Commerce ... among the several
States. ..." [10]

Madison expected that Congress would do little to regulate interstate
commerce. It was his concept that the Commerce Clause would, in
effect, preempt the states from interfering with interstate commerce.
In practice, the Commerce Clause did not discourage the states from
interfering with interstate commerce and Congress did little, if
anything, to constrain them. As a consequence, while Madison intended
that the Commerce Clause would almost be self operating in fostering
economic union, in the absence of congressional action the courts
were left to implement the economic union through ad hoc interpretation
of the Commerce Clause.

The courts and the Commerce Clause

The Commerce Clause contains an ambiguity: It gives Congress the
power to regulate interstate commerce but does not expressly prohibit
the states from interfering with interstate commerce. To address
this ambiguity, the Court developed a doctrine known as the "dormant"
or "negative" Commerce Clause, which it applies, in the absence
of congressional action, to strike down state laws that it has determined
excessively burden interstate commerce.

The Court has supported the ideal of an economic union through
its application of the dormant Commerce Clause. However, contrary
to Madison's vision of the Commerce Clause, the Court will tolerate
some state action that imposes a burden on interstate commerce if
the burden is not excessive in relation to the benefit accruing
to the state from a legitimate local public purpose. A legitimate
local public purpose is one for health, safety or welfare, including
the economic welfare of the state. The Court recently has said that
"a pure subsidy funded out of general revenues ordinarily imposes
no burden on interstate commerce, but merely assists local business."[11] (Emphasis added.) In an earlier decision, and more directly to the
point of this essay, the Court said that "a State's goal of bringing
in new business is legitimate and often admirable."[12] (Emphasis added.)

Therefore, if the Court were to consider the constitutionality
of a state subsidy or preferential tax to attract or retain businesses,
one would expect it to hold[13] that
subsidies or preferential taxes impose no burden on interstate commerce.
Even if the Court were to decide that such a state subsidy or tax
preference burdens interstate commerce, it would weigh that burden
against what it would undoubtedly regard to be a legitimate local
public purpose, attracting and retaining businesses.

In any case, the Court may not wish to act because Congress has
remained silent.[14] The failure of
Congress to speak to an issue can have a profound effect on the
Court. When Congress remains silent after the Court has clearly
expressed a position in the area of interstate commerce, the Court
is likely to regard that silence as tacit approval. Therefore, the
Court, having clearly expressed the view that state subsidies to
attract and retain businesses do not interfere with interstate commerce,
including twice during its 1993-94 term, may take the silence of
Congress to be tacit approval.

Finally, the courts are not a practical vehicle for preventing
the states from using subsidies and preferential taxes to attract
and retain particular businesses. The courts, including the Supreme
Court, do not have the power to prevent the states from interfering
with interstate commerce. A court can only consider the constitutionality
of a state law in the context of a particular case that is before
it. As a consequence:

Spasmodic and unrelated instances of litigation cannot afford an
adequate basis for the creation of integrated national rules which
alone can afford that full protection for interstate commerce intended
by the Constitution. We would, therefore, leave the questions raised
... for consideration of Congress. ...[15]

Congress can and should prohibit state business subsidies and
preferential taxes

The Supreme Court must be credited with implementing the Commerce
Clause and preserving Madison's objective of an economic union.
Congress has done little to foster the intended purpose of the Commerce
Clause. However, the Court can only decide the cases and controversies
that come before it. It can't create laws to implement the Commerce
Clause.

Only Congress has the power to enact legislation to prohibit and
prevent the states from using subsidies and preferential taxes to
compete with one another for businesses. In addition to its power
under the Commerce Clause, Congress has the ancillary power it derives
from its power to tax and appropriate money, and the power to make
all laws that are needed to carry out its enumerated constitutional
powers. Moreover, under the Supremacy Clause the Constitution and
the laws of the United States are the supreme law of the land.

The power of Congress under the Commerce Clause is so sweeping
that to enact legislation to prohibit the states from using subsidies
and preferential taxes to compete with one another, it need only
make a finding, formal or informal, that such subsidies and taxes
substantially affect interstate commerce. The Supreme Court will
defer to such a congressional finding if there is any rational basis
for the finding. No Supreme Court decision in at least the past
50 years has set aside federal legislation on the ground that Congress
did not have a rational basis for such a finding.[16] The Court has recognized that the power of Congress under the Commerce
Clause even extends to intrastate activities that have a substantial
effect on interstate commerce. Moreover, Congress can legislatively
supplement, revise or overturn any of the Court's decisions under
the dormant Commerce Clause doctrine.

To illustrate how Congress might discourage states from using
subsidies and preferential taxes to compete with one another for
businesses, consider the variety of subsidies and preferential taxes
a city and state might use to attract a sports franchise away from
another city. It would not be unusual for them to offer some or
all of the following: 1) build a stadium funded by public, tax-exempt
debt, 2) lease the stadium to team owners at bargain rent, 3) rebuild
streets and highways to provide stadium access, 4) loan or grant
the team owners relocation funds, 5) pay for land with tax increment
financing on which team owners can build an office building, and
6) grant the team owners a real estate tax abatement on the building.
To implement a legislative prohibition, Congress could impose sanctions
such as taxing imputed income, denying tax-exempt status to public
debt used to compete for businesses and impounding federal funds
payable to states engaging in such competition.

Conclusion

Unfettered competition among private businesses has generally
proven to be a very successful economic system. As Adam Smith predicted
over 200 years ago, individuals acting in their own best interest
are led, as if by an invisible hand, to produce what is best for
the overall economy. And experience has shown that Smith was right.
Those countries that have relied on a market-oriented economy have
outperformed (based on virtually all measures of success) those
countries that have relied on a central planning strategy.

But what is true of individuals acting in their own interest is
not necessarily true of state governments acting on behalf of their
local citizens. Competition among governments based on their general
tax and spend policies leads to a better outcome for the overall
economy. However, when that competition takes the form of preferential
financial treatment for specific companies, the overall economy
is made worse off. Such competition results in a misallocation of
resources and, in particular, too few public goods.

Competition among states for specific businesses is commonplace
and growing more costly. Most states today have put in place some
type of economic development program to attract and retain businesses.
While some state officials have questioned the economic wisdom of
this type of competition, there is little likelihood that the states
will successfully establish either formal or informal non-compete
agreements, because it appears that the incentive to cheat is too
great.

The Supreme Court, which has, for the most part, been the surrogate
for Congress in preventing activities that interfere with interstate
commerce, is not equipped to end this economic war among the states.
To the extent that it has power to do so, there is little, if anything,
in its decisions to date that suggest that it would.

Only Congress, with its sweeping constitutional powers, particularly
under the Commerce Clause, has the ability to end this economic
war among the states. And it is time for Congress to act.

Burstein is executive vice president and general counsel of
the Federal Reserve Bank of Minneapolis and Rolnick is senior
vice president and director of Research. The authors wish to acknowledge
the invaluable assistance of Thomas Holmes, economist, Federal
Reserve Bank of Minneapolis, and Gary Spiegel, a senior at the
University of Minnesota Law School. The views expressed herein
are those of the authors and not necessarily those of the Federal
Reserve Bank of Minneapolis or the Federal Reserve System.

Endnotes

[2] John Helyar, "Beat Me in St. Louis," Wall
Street Journal, January 27, 1995, at 1A.

[3] Jane Seaberry, "Amarillo Lures Business With $8
million Checks," Dallas Morning News, September 13,
1994, at 1D. Until this economic development initiative, Amarillo
was best known for its farming, ranching and flat terrain.

[5] Unless the context clearly indicates otherwise,
all references to "state" or "states" are intended to include local
government units as well. For purposes of the Commerce Clause it
should not make any difference whether subsidies and preferential
taxes are offered by states or local governmental units. Most, if
not all, subsidies and preferential taxes are offered by the local
government under state enabling legislation, and part of the cost
of the benefit is, directly or indirectly, borne by the state.

[7] For a formal analysis of this proposition, see
Thomas Holmes, "The Effects of Tax Discrimination When Local Governments
Compete for a Tax Base," Research Department Working Paper 544,
Federal Reserve Bank of Minneapolis, 1995.

[8] Holmes (1995) finds that, in general, the overall
economy is worse off when states use preferential tax treatment
to attract or retain businesses. In those cases where the overall
economy might be better off, the net gain is very small and turns
negative if the tax on immobile firms becomes too high.

[9] Most of our discussion about the judiciary's role
in effectuating the Commerce Clause concerns the U. S. Supreme Court,
which we will sometimes refer to as "the Court." Although the Court
reviews only a very small number of all the cases involving the
Commerce Clause, its holdings are controlling in the absence of
federal legislation on the subject. Occasionally, however, we will
make more general references to "the courts," which apply decisions
of the Court on the Commerce Clause to the cases before them. The
term "the courts" will usually include both federal and state courts.
Our use of the terms "the Court" and "the courts" is deliberate
and the difference in meaning should be clear from the context within
which the term is used.

[13] The term "hold" or "holding" refers to the specific
issue being decided by the Court. For example, in the West Lynn
Creamery case the Court held that the Massachusetts tax on fluid
milk unconstitutionally discriminated against interstate commerce.
The holding of the Court should be distinguished from observations
the Court makes in its opinions. Although such observations may
be persuasive evidence of how the Court or a particular justice
might rule in a future case before the Court, the observation cannot
be cited as authority for a legal proposition.

[14] See, e.g., Federal Baseball Club of Baltimore,
Inc. v. National League of Professional Baseball Clubs, 259 U.S.
200 (1922). In this case, the Court held that professional baseball
was exempt from antitrust legislation because it was not engaged
in commerce among the states. No one today would seriously argue
that professional baseball is not engaged in commerce among the
states; nevertheless, the Court has never overturned that decision,
in part because Congress has been silent on the issue.